1. Field of the Invention
The invention relates to a method for processing certain financial and demographic data to define complementary terms for several related agreements, including an employer/employee agreement, a life insurance policy and a third party loan secured by the policy, and in so doing to apply certain revenue rules regarding permissible premium payment proportions and payment timing for adjusting a schedule of payments. The invention provides a convenient means to arrive at a workable tax-minimized arrangement for key employees to accumulate value with the assistance of their employers.
2. Prior Art
Life insurance is useful as an investment or savings tool as well as for its basic object of providing a death benefit payment to a beneficiary. This is true because a whole life policy develops a cash value. The cash value can be borrowed against, and any loans that are outstanding at the time of death can be settled from the death benefit. Such insurance is distinct from term insurance, which does not develop a cash value and is characterized by increasing premium rates as the insured person ages.
An employer may find it appropriate to provide group life insurance to employees as a benefit. For example, an employer may provide group term life insurance on employees, financing the coverage itself or paying experience-rated rates. An employer providing such insurance, either alone or in conjunction with an insurance company, can at the same time provide term insurance naming the employees' beneficiaries, and also obtain insurance on the employees under policies naming the employer as beneficiary, to minimize the possibility of undue financial burden should an unusually large number of insured employees die over a short time. If the employer takes out whole life insurance (known as corporate-owned life insurance) in such an arrangement, the employer can borrow against the cash value, should the need arise.
In general, the death benefit of an insurance policy is not taxable to the beneficiaries or to the estate of the insured. Internal Revenue Code Section 79, which concerns term life insurance, imposes imputed income on an employee with respect to company-paid insurance over a stated maximum ($50,000). This section reduces the extent to which conventional insurance arrangements as above may shelter income from taxes. As explained in U.S. Pat. No. 5,429,506--Brophy et al., the disclosure of which is hereby incorporated, it may be desirable to combine a premium paying corporate life insurance plan with a voluntary employee group life plan. The premiums are split between the employer and the employee so as to provide a designated death benefit to the beneficiaries of the employee, while enabling the employer to invest funds in the cash value of the life insurance contract so as to help fund the group life benefits. As explained in the Brophy patent, there are a number of problems with attempts to make life insurance into a workable employee benefit plan having a cash value for the employee, while avoiding unnecessary taxation of either the employer or employee, as well as undue risk for the employer.
There are various investment and savings techniques, including life insurance, and the different techniques carry different tax implications. In a "split dollar" insurance plan, payments are made by both the employer and by the employee. Payments by the employer are tax deductible business expenses, but payments by the employee must be made from after-tax income. The death benefit is not taxable under the present Internal Revenue Code. The employee's contribution effectively is taxed because it comes from after-tax income, and as such resembles a savings plan without tax liability as to appreciation (i.e., if the difference between the death benefit and the amounts paid in is positive).
Comparing the tax consequences of various investment vehicles, there is no savings, investment and/or insurance technique that avoids taxation with respect to each of a contributing employer, employee and beneficiary. Investments in commodities that may appreciate, for example interest bearing accounts, mutual funds and the like, all are made from after-tax income. Appreciation income on liquidation of such investments is taxable (except perhaps in the case of municipal bonds). Qualified retirement plans, 401(k) plans and individual retirement accounts accumulate untaxed income, but taxes are simply deferred. The accumulated value is taxable at the taxpayer's tax rate when money is taken out of the tax deferred account. In addition there are limits on the amount of income that can be accumulated in tax-deferred accounts. The employer also may be required to make the plan available equally to all employees in order for the plan to qualify for tax-deferred treatment. Thus, such accounts cannot be used as a means to compensate key employees.
Term life policies are characterized by increasingly higher premium rates as the insured ages. Whole life policies, on the other hand, normally have constant premiums but the premiums are substantially higher than term insurance premiums. During the life of the insured, the premiums paid in are invested by the insurance company. Income on paid-in premiums covers part of the death benefits payable, and also enable the insurance company to obtain a profit.
The cash value of a whole life policy increases with aging of the insured, and can be borrowed against. Conversely, it is possible to borrow money for use as payment of an insurance premium. It would appear that borrowing to pay insurance premiums would be financially quite unfavorable for the insured. The insured would need to encumber collateral to secure the loan, and would incur interest charges on the loan. At least the principal payments on the loan would be from after tax income. Such an arrangement would appear beneficial only to insurance companies in that additional policies could be sold. Insurance companies have attempted to market insurance products comprising a loan by the insurance company to the insured of at least a portion of the premiums payable on a policy, with the cash value of the policy and the death benefit providing collateral for the loan. Due to interest on the loan premium and payments from after-tax income, this "leveraged" insurance can be expected to have a poor overall rate of return when all factors are considered.
In any life insurance arrangement, the insurer calculates the appropriate premium payment as a function of mortality rates and the expected return on investments made with premiums paid in by all its insured persons, so that claims can be paid while earning a profit. In some plans the insured pays in more than the premium thus calculated, and the return on the investment of the excess (e.g., as interest) defrays part of the premium that would otherwise be payable. When an insurance policy is fully paid up such that the return on the insurer's investment of paid-in amounts covers all further premiums, the policy resembles a purchased annuity, a certificate of deposit or an interest bearing account.
There are Internal Revenue Service limits on the extent to which premiums can be borrowed or paid in early so as to enable investment of the premiums to provide a return, while retaining the favorable tax treatment of a life insurance death benefit. Over the first seven years of a policy, for example, at least four parts in seven of premiums due must be paid in rather than borrowed. Internal Revenue Service and court rulings also distinguish an insurance policy from a modified endowment contract or an annuity. To be considered an insurance policy, less than 73% of the premiums due can be paid in over the first four years. Rules and regulations also define the permissible net single premium (NSP), guideline level premium (GLP) and guideline single premium (GSP). Failure to comply with such regulations, promulgated under DEFRA or TAMARA, can cause an ostensible insurance policy to be treated as a taxable investment, or may change the order in which payments made or withdrawn are deductible. For example under TAMARA, proceeds of the policy can be considered taxable income first, and deductible basis last, changing from a first-in-first-out taxation order to a last-in-first-out order.
The DEFRA and TAMARA guidelines and similar regulations need to be observed to retain favorable tax treatment, but the rules are normally applied retrospectively. For example, the proportions of payments made are considered when the IRS conducts an audit or when an accountant assesses taxes that are due on activity during the previous year.
Various inter-related factors are involved in considering the possibility of borrowing to pay insurance premiums. These include at least: the rate of interest payable on any loan taken out to pay premiums; the cash value at any given time and the amount of the death benefit (which will provide collateral for the loan); employee borrowing against the insurance policy; the proportion of premiums borrowed vs. the proportion paid-in, as well as the timing when particular amounts are to be paid; the proportion applied from after-tax income (by an employee) vs. deducted as a business expense (by an employer); the return on insurance company investment of paid-in contributions to meet scheduled premiums as provided by the terms of the insurance policy and the effect of unscheduled premiums (i.e., prepaid premiums); the employee's tax rate; and, the legal rules and limitations designed to exclude endowments from favorable tax treatment.
All these factors vary with the circumstances. What is needed, and provided according to the present invention, is a data processing method that provides a practical insurance and investment product that meets the definitions of a proper insurance contract so as to qualify for favorable tax treatment, while ensuring that the investment of each of the parties is protected and not subject to undue risk. The object is to dovetail the terms of an insurance contract, a loan agreement and an employer/employee agreement, such that premiums are paid partly by the employer and partly by the employee, including via borrowed money, to provide for premium payments, to comply with IRS regulations and favorable tax treatment, and to permit the employee to accumulate value over a working career.
The method is accomplished by storing in a file a set of constants that characterize the terms of at least one and potentially several alternative available life insurance contracts and loan agreements, which can be the offerings of different companies. Variables are then stored in a second file to characterize the situation of one or more particular employees, including each employee's tax rate, and including insurance related information such as age and potentially also health status information (e.g., smoking or nonsmoking). Also stored in the variables file are an amount that an employer is willing to contribute, or a desired cash or death benefit value to the employee, or both. The terms of a loan to pay premiums on the insurance policy then are calculated so as to include unscheduled (prepaid) premiums sufficient to have the policy fully paid within a predetermined time period. A set of limiting rules are then applied and a division of payments is made between the employer and employee to result in a payment schedule. The calculations and limiting rules ensure compliance with the tax codes and ensure that the value of the policy will provide sufficient collateral to cover the loan through the term of the agreement. Complementary terms of agreement are thereby defined between or among the employer, the employee, the lender and the insurer. In this manner, an insurance policy can provide a vehicle for accumulating value in a tax-minimized, safe and legal manner.